Tuesday, September 30, 2008

market-to-market accounting

Companies such as Enron and likely many of the players in today's mortgage mess used “market-to-market accounting”. Enron used these rules for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions. It looks like the players in the Mortgage mess also used market-to-market accounting. Under market-to-market rules, whenever companies have outstanding derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period. A difficulty with application of these rules in accounting for long-term futures contracts such as Mortgage Securities is that there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods. The Financial Accounting Standards Board’s (FASB) emerging issues task force has debated the subject of how to value and disclose related contracts for several years. It has been able to conclude only that a one-size-fits-all approach will not work and that to require companies to disclose all of the assumptions and estimates underlying earnings would produce disclosures that were so voluminous they would be of little value. For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.

Citigroup

Revenue (2007) 80,707 (06) 88,453 (05) 82,1479

Net Income 3,617 21,538 24,589

When I look at these numbers I see something wrong. Why did Citigroup show profits in 2007 of $3,617,000,000 a drop of about $18,000,000,000 from the previous. In accounting everything will come out sooner or later. Ask the Arthur Andersen accounting firm oh yeah the Enron debacle put them out of business. Maybe you could visit the federal prison in Waseca, Minn. and ask Jeffrey Skilling.

I have been saying these last few months that I want to see some CEO's heads roll -- all the way through the court system -- and into a prison cell. Their greed is bringing our great country to its knees. I wait with anticipation of reading about the arrests and subsequent trials of these thieves.

the valuation of derivatives is problematic to say the least. at least with mortgage backed securities in the end you have the physical real estate backing them, which will probably have some value. But derivatives contingent on future events? Intangible probabilities? Seems like every valuation would be a form of gambling because you'd just be playing the odds.